Financial Sector Assessment
Consolidated Supervision
Consolidated supervision is a supervisory tool that was developed in response to the growing trend in financial institutions of diversifying their activities across national borders and sectoral boundaries through ownership linkages. The creation of diversified financial groups raises additional supervisory concerns, including contagion, conflicts of interest, lack of transparency, and regulatory arbitrage. Supervisory and regulatory arrangements are geared at mitigating those concerns to ensure that risks are properly managed and that they do not threaten the safety and soundness of the financial system.
Consolidated supervision may be broadly defined as a qualitative and quantitative evaluation of the strength of a financial group that consists of several legal entities under common ownership or control. The objective of consolidated supervision is (a) to ensure the safety of the financial system through monitoring and evaluating the additional risks posed to the regulated financial institutions by the affiliated institutions in the financial group and (b) to assess the strength of the entire group. Consolidated supervision should have both quantitative and qualitative elements:
• Quantitative consolidated supervision focuses on issues such as asset quality, capital adequacy, liquidity, and large exposures that are measured on a consolidated basis. There is clearly a requirement that the group be able to produce (a) comprehensive on-balance sheets and off-balance sheet data and (b) counterparty information. This input should be in a form sufficient for reliable capital adequacy, liquidity, and exposure concentration calculations to be made. Because different entities in the group may be subject to different accounting regimes, the results of accounting consolidation may need to be treated with caution.
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Qualitative consolidated supervision is closely identified with comprehensive risk - based supervision, which is designed to assess how well management identifies, measures, monitors, and controls risks in a timely manner. This supervision will involve an assessment of the wider risks posed by other group companies in terms of their effect on the regulated entity. This assessment is likely to involve the
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risks. In addition, for contracts with deferred delivery of products, significant additional price risks arise.
Unique Risks of Islamic Banking
Addressing the unique risks of Islamic banking requires adequate capital and reserves, as well as appropriate pricing and control of risks in a suitable disclosure regime. Because information asymmetries are particularly acute in Islamic banking, the need for strong rules and practices for governance, disclosure, accounting, and auditing rules is paramount. The development of an infrastructure that facilitates liquidity management is also a key priority. The challenge for supervisors in ensuring that this type of framework is in place is made more difficult by the absence of uniform prudential and regulatory rules and standards. Currently, there is no uniformity in income-loss recognition, disclosure arrangements, loan classification and provisioning, treatment of reserves, practices in income smoothing, and so forth, although standards for those elements have been developed—and are in increasing use—by accounting and auditing organizations for Islamic financial institutions.
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Islamic banking poses unique risks to the financial system because of the profit-and-loss-sharing (PLS) modes of financing and specific contractual features of Islamic financial products.3 PLS not only shifts the risks in the institution to investment depositors to some extent but also makes Islamic banks vulnerable to a range of risks (including those normally borne by equity investors) because of the following features:
• Administration of PLS is more complex, requiring greater auditing of projects to ensure proper governance and appropriate valuation.
• PLS cannot be made dependent on collateral or guarantees to reduce credit risk.
• Product standardization is more difficult because of the multiplicity of potential financing methods, the increasing operational risk, and the legal uncertainty in interpreting contracts.
• Liquidity risks are substantial because of the inability to manage asset and liability mismatches as a result of the absence of Sharia-compliant instruments such as treasury bills and lender-of - last-resort facilities.
The presence of commodity inventories in Islamic bank balance sheets adds to operational and price
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a. The Islamic Financial Services Board (IFSB) was established to adopt regulatory practices and policies to the specific features of Islamic finance and to promote its development. Establishment of IFSB was facilitated by IMF so it can develop prudential standards for Islamic banking and can foster effective risk management. Several IFSB working groups are developing standards and guidelines on capital adequacy, risk management, corporate governance, Islamic money markets, and market discipline and transparency; in addition, draft standards on capital adequacy and risk management have been issued for public comments.
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identification of significant activities or business units and an understanding not only of their role within the group but also of the risks to the group posed by their activities.
Some of the key issues and principles governing consolidated supervision are summarized in Annex 5.B.
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